Could China be leading the broader markets down? I think it's very possible. China's been the posterchild of this monster rally - "Look everyone, China's doing OK!" And if China's not really doing so hot...uh oh!

In reality I think we've seen a lot of smoke and mirrors from a government desperate to keep the economy rolling. They've used enough forms of "economic steroids" to make a MLB slugger proud.

With Chinese stocks off nearly 25% since August 4th, I'd be very cautious right now about equities in general.

Sunday, August 30, 2009

Three weeks ago, we discussed the possibility the the dollar was bottoming and poised for a major rally.

My reasoning was that:

Sentiment was overwhelmingly negative on the buck. I noticed that even traditional contrarian investment sources appeared to be piling on. When there's nobody left to sell, that's usually a good sign that the bottom is in.

We still appear to be in a period of debt deflation, which the Federal Reserve is basically helpless in preventing, because we have a credit based system. When credit goes away, it's gone forever. You can't print credit.

The Japanese Central Bank, despite its best efforts, was ultimately unable to produce inflation since their credit bubble popped in 1990. And if the old joke is that their central bank was so incompetent that it couldn't destroy its own currency, I didn't know why ours would be any different.

What's happened in the last few weeks?

Pulling up the chart, the dollar appears to be forming a bottom. The 77 mark has held:

Is the buck bottoming?

(Source: Barchart.com)

The equity and commodity markets look toppy. Investor sentiment is overwhelmingly bullish. The AAII index, a very reliable contrarian indicator, is at levels not seen since November 2007.

Furthermore, China, the posterchild of this rally, has turned down - the Shanghai Index rolled over a few weeks ago...along with several key commodities. Gold is yet to break $1,000 decisively, despite the widespread belief that the Fed has successfully created inflation.

Add it all up, and we've got some very bearish pieces staring us in the face. And if we do see another massive deflationary wave down...is there any reason to believe it will behave differently than the last?

I don't think so. So I'm taking some cues from the markets, and positioning myself in the only asset that held up and even rallied the last time around - the US dollar.

Take Note When Bears are Bullish

One of our astute readers took me to task when I said Robert Prechter was not a perma-bear. In fact, this reader made a very good case, pulling up some old doomsday calls of Prechter's that look silly in hindsight.

We had a good back and forth debate - I accepted his points, but added that Prechter has called this rally to a tee, which was a bullish call.

Ultimately our reader summed it up perfectly:

Funny thing is he has called 2 rallies well 1980s bull market and this most recent rally.

He gets in trouble once he goes bearish (which he has been 18 of the last 20 years). Had he gotten away from this stupid (dow 400, great depression II) perma outlook of his, he would be much better. Then again, maybe its this permabearishness that somehow, someway gives him the ability to call rallies.

Maybe the real take away - the lesson of the last 20 years, is heed his calls of rally, ignore his calls of doom. Imagine how well we would have done!!! ;

A hilarious, and very insightful conclusion! We should especially take heed when the bearish types turn bullish!

I suppose the counterpoint would also be a wise one - be wary when perma-bulls turn bearish!

Positions Update

Still holding cotton - barely - and now we're taking a flyer on the buck.

It's tough to sell cotton here - and also tough to get excited about it. In a healthy global economy, cotton's fundamentals would appear to justify higher prices right now. The fact that we don't have them gives me pause that something is amiss - perhaps cotton is telling us that things may not be so fine and dandy.

The newsletter that I most look forward to these days is Bob Prechter's...his views are unique, insightful, and I'm really starting to believe he's one of the only guys with a clue right now!

It's important to mention that while Prechter is extremely bearish now, he's by no means a perma-bear. I tend to discount folks who are perenially bearish - because even a broken clock is right twice a day! I want to follow the "gurus" who get the bullish and bearish angles right, at the right time.

I just got done reading Prechter's Elliott Wave Principle book, which I'll be doing a review on soon in this space. It's a great read - written in the late 70's, Prechter used it to outline his case for a massive bull market to come.

With the DOW floundering below 1000, and many financial types speculating that the US economy was in a state of permantent plateau/decline, Prechter put an aggressive 3000 price target on the DOW in what he predicted would be "the mother of all bull markets." Of course the bull ran much higher and longer than even Prechter envisioned, but as far as I can find, he made the most aggressive, correct call, during that time period. (Other examples are greatly appreciated!)

With that, here's a free excerpt from Prechter's latest newsletter - with an opportunity from EWI to get your hands on the entire piece. Enjoy!

***

The Bounce Is Aging, But The Depression Is YoungAugust 26, 2009

By Bob Prechter

The following is an excerpt from Robert Prechter's Elliott Wave Theorist. Elliott Wave International is currently offering Bob's recent Elliott Wave Theorist, free.

On February 23, EWT called for the S&P to bottom in the 600s and then begin a sharp rally, the biggest since the 2007 high. The S&P bottomed at 667 on March 6. Then the stock market and commodities went almost straight up for three months as the dollar fell.

On March 18, Treasury bonds had their biggest up day ever, thanks to the Fed’s initiating its T-bond buying program. The next day, EWT reiterated our bearish stance on Treasury bonds. T-bond futures declined relentlessly from the previous day’s high at 130-15 to a low of 111-21 on June 11.

That’s when there were indications of impending trend changes. The June 11 issue called for interim tops in stocks, metals and oil and a temporary bottom in the dollar. The Dow topped that day and fell nearly 800 points; silver reversed and fell from $16 to $12.45; gold slid about $90; and oil, which had just doubled, reversed and fell from $73.38 to $58.32. The dollar simultaneously rallied and traced out a triangle for wave 4. Bonds bounced as well. As far as I can tell, our scenarios at all degrees are all on track.

Corrective patterns can be complex, so we should hesitate to be too specific about the shape this bear market rally will take. But from lows on July 8 (intraday) and 10 (close), the stock market may have begun the second phase of advance that will fulfill our ideal scenario for a three-wave (up-down-up) rally. In concert with rising stocks, bonds have started another declining wave, and the dollar appears to have turned down in wave 5 (see chart in the June issue), heading toward its final low. Although commodities should bounce, their wave patterns suggest that many key commodities will fail to make new highs this year in this second and final phase of partial recovery in the overall financial markets.

Meanwhile, our forecast for a change in people’s attitudes to a less pessimistic outlook is proceeding apace. Here are some of the reports evidencing this change:

More than 90 percent of economists predict the recession will end this year. [The] vast majority pick 3rd quarter as the time. (AP, 5/27)

Manufacturing and housing reports this week may offer signs that the recession-stricken U.S. economy is within months of hitting bottom, economists said. (USA, 6/15)

Fewer people say they’ve prospered over the past year than in decades, a USA TODAY/Gallup Poll finds. Over the past two months, however, expectations for the future have brightened significantly amid rising optimism about a stock market rebound and economic turnaround. “I think the administration is going in the right direction,” says… Now 36% of those surveyed in the Gallup-Healthways well-being poll say the economy is getting better. That’s not exactly head-over-heels exuberance, but it is double the number who felt that way at the beginning of the year and a notable spike in the nation’s frame of mind. Thirty-three percent say they’re satisfied with the way things are going in the United States; in January, just 13% did. (USA, 6/23/09)

If only to confirm the socionomic causality at work, an economist quoted in the article above muses, “The one anomaly in the puzzle is that people shouldn’t be feeling better because the jobs market is so terrible and unemployment is likely to keep rising.” Of course it would be an anomaly, and people should not feel better, if mood were exogenously caused. But it is endogenously regulated, and it precedes social actions, which produce events such as job creation and elimination. That people feel better is evident in our rising sociometer, the stock market. If the rally continues, economists will soon agree that the Fed’s “quantitative easing” and Congress’ massive spending are “working.” Those predicting more inflation and hyperinflation will have the last seeming confirmation of their opinions. Then, a few months from now, some economists will probably express similar puzzlement when the stock market starts plummeting again despite the fact that the economy has improved.

But all of these considerations are temporary. Conditions are relative, and behind the scenes, the depression has been, and still is, grinding away.

For more information, download the FREE 10-page issue of Bob Prechter’s recent Elliott Wave Theorist. It challenges current recovery hype with hard facts, independent analysis, and insightful charts. You’ll find out why the worst is NOT over and what you can do to safeguard your financial future.

Sunday, August 23, 2009

As financial pundits and common investors breath collective sighs of relief that "the worst is over" and "the bull is back", let's explore the possibility that 2009 may be following a script that was originally penned in 1930.

After the initial crash in 1929, the markets staged a powerful rally that retraced 60% of these losses...

What "solutions" were being heralded in 1930 as saving economic graces? "The coordination of business and government agencies in concerted action," according to Hoover.

Sound familiar?

Finally, I find it very interesting that during these times, the Fed's actions were viewed as wildly inflationist. From Murray Rothbard's America's Great Depression:

If the Federal Reserve had an inflationist attitude during the boom, it was just as ready to try to cure the depression by inflating further. It stepped in immediately to expand credit and bolster shaky financial positions. In an act unprecedented in its history, the Federal Reserve moved in during the week of the crash—the final week of October—and in that brief period added almost $300 million to the reserves of the nation’s banks. During that week, the Federal Reserve doubled its holdings of government securities, adding over $150 million to reserves, and it discounted about $200 million more for member banks. Instead of going through a healthy and rapid liquidation of unsound positions, the economy was fated to be continually bolstered by governmental measures that could only prolong its diseased state.

President Hoover was proud of his experiment in cheap money, and in his speech to the business conference on December 5, he hailed the nation’s good fortune in possessing the splendid Federal Reserve System, which had succeeded in saving shaky banks, had restored confidence, and had made capital more abundant by reducing interest rates.

Bottom line: While history may never exactly repeat, it certainly has a tendency to rhyme (to quote Mark Twain). Cast a skeptical eye on folks who believe that we're through the worst - we're not through anything yet!

Right now, we're exactly on pace with 1930. While we can't be sure that history will repeat (or rhyme) - it's too early to rule out this possiblity as well. Proceed with caution!

Thursday, August 20, 2009

Raise your hand if, a few years ago, you thought you'd see Natural Gas trading below $3 ever again. I never expected it. Yet here we are, just a few years after there was talk of "Peak Nat Gas" in North America, with the Natty sliding below $3.

And what a slide it's been!

Turns out the cure for high prices was high prices.

(Source: Barchart.com)

This is why I don't have a hard time seeing crude oil back in the $20's or $30's at some point. Peak Oil guys will get red in the face, saying how it's impossible. In fact, check out the angry commenter on this $20 Oil post, who called me a Moron!

Now he may very well be right - but I can't help but wonder that if high prices can bring so much Nat Gas on the market, what's so different about oil?

What's the downside on Natural Gas here? Obviously pretty limited - at most it's $2.90! Not a bad lottery ticket to think about playing with hurricane season rolling around. Though I'd like to see some more negativity on this as a speculation, before I think about trading it myself.

Ever since the Natty broke $5, we've been hearing how cheap it was, how it's a great speculation at these prices. Then it broke $4. Now it broke $3. Let's see it break the back of a few more bulls before we take a look at this as a speculation.

Wednesday, August 19, 2009

Here's a great guest essay I'm pleased to be able to share, from none other than Doug Casey. Nobody can rip into someone quite like Doug in my book. Please read on as Doug gives Baby Bush a belated, but not gentle, bon voyage essay.

If you're offended by this one - you can take some solace in the fact that Doug is an equal opportunity offender when it comes to politicians. In fact, I can't recall hearing him speak decently of any one of them, save perhaps Ron Paul.

I recognize that I’ve antagonized many subscribers over the years with “Bush Bashing.” In January, just after OBAMA!’s election, I said I wouldn’t mention Bush again, his departure having made him irrelevant. I only feel bad that he and his minions will apparently get away scot-free with their crimes; better they had all been brought up before a tribunal and tried for crimes against humanity in general and the U.S. Constitution in particular. But that is objectively true of almost all presidents since at least Lincoln.

Most of our subscribers to The Casey Report appear to be libertarians or classical liberals – i.e., people who believe in a maximum of both social and economic freedom for the individual. The next largest group are “conservatives.” It’s a bit harder to define a conservative. Is it someone who atavistically just wants to conserve the existing order of things (either now, or perhaps as they perceived them 50, or 100, or 200, or however many years ago)? Or is a conservative someone who believes in limiting social freedoms (generally that means suppressing things like sex, drugs, outré clothing and customs, and bad-mouthing the government) while claiming to support economic freedoms (although with considerable caveats and exceptions)? It’s unclear to me what, if any, philosophical foundation conservatism, by whatever definition, rests on.

Which leads me to the question: Why do conservatives seem to have this warm and fuzzy feeling for George W. Bush? I can only speculate it’s because Bush liked to talk a lot about freedom and traditional American values, and did so in such an ungrammatical way that it made him seem sincere. Bush’s tendency to fumble words and concepts contrasted to Clinton’s eloquence, which made him look “slick.”

I’m forced to the conclusion that what “conservatives” like about Bush is his style, such as it was. Because the only good thing I can recall that Bush ever did was to shepherd through some tax cuts. But even these were targeted and piecemeal, tossing bones to favored interests, rather than any principled abolition of any levies or a wholesale cut in rates.

Is it possible that Bush was actually the worst president ever? I’d say he’s a strong contender. He started out with a gigantic lie -- that he would cut the size of government, reduce taxes, and stay out of foreign wars -- and things got much worse from there. Let’s look at just some of the highpoints in the catalog of disasters the Bush regime created.

No Child Left Behind. Forget about abolishing the Department of Education. Bush made the federal government a much more intrusive and costly part of local schools.

Project Safe Neighborhoods. A draconian law that further guts the 2nd Amendment, like 20,000 other unconstitutional gun laws before it.

Medicare Prescription Drug Benefit. This the largest expansion of the welfare state since LBJ and will cost the already bankrupt Medicare system trillions more.

Sarbanes-Oxley Act. Possibly the most expensive and restrictive change to the securities laws since the ‘30s. A major reason why companies will either stay private or go public outside the U.S.

Katrina. A total disaster of bureaucratic mismanagement, featuring martial law.

Ownership Society. The immediate root of the current financial crisis lies in Bush’s encouragement of easy credit to everybody and inflating the housing market.

Nationalizations and Bailouts. In response to the crisis he created, he nationalized Fannie Mae and Freddie Mac and passed by far the largest bailouts in U.S. history (until OBAMA!).

Free-Speech Zones. Originally a device for keeping war protesters away when Bush appeared on camera, they’re now used to herd.

The Patriot Act. This 132-page bill, presented for passage only 45 days after 9/11 (how is it possible to write something of that size and complexity in only 45 days?) basically allows the government to do whatever it wishes with its subjects. Warrantless searches. All kinds of communications monitoring. Greatly expanded asset forfeiture provisions.

The War on Terror. The scope of the War on Drugs (which Bush also expanded) is exceeded only by the war on nobody in particular but on a tactic. It’s become a cause of mass hysteria and an excuse for the government doing anything.

Invasions of Afghanistan and Iraq. Bush started two completely pointless, counterproductive, and immensely expensive wars, neither of which has any prospect of ending anytime soon.

Dept. of Homeland Security. This is the largest and most dangerous of all agencies, now with its own gigantic campus in Washington, DC. It will never go away and centralizes the functions of a police state.

Guantanamo. Hundreds of individuals, most of them (like the Uighurs recently in the news) guilty only of being in the wrong place at the wrong time, are incarcerated for years. A precedent is set for anyone who is accused of being an “enemy combatant” to be completely deprived of any rights at all.

Abu Ghraib and Torture. After imprisoning scores of thousands of foreign nationals, Bush made it a U.S. policy to use torture to extract information, based on a suspicion or nothing but a guard’s whim. This is certainly one of the most damaging things to the reputation of the U.S. ever. It says to the world, “We stand for nothing.”

The No-Fly List. His administration has placed the names of over a million people on this list, and it’s still growing at about 20,000 a month. I promise it will be used for other purposes in the future…

The TSA. Somehow the Bush cabal found 50,000 middle-aged people who were willing to go through their fellow citizens’ dirty laundry and take themselves quite seriously. God forbid you’re not polite to them…

Farm Subsidies. Farm subsidies are the antithesis of the free market. Rather than trying to abolish or cut them back, Bush signed a record $190 billion farm bill.

Legislative Free Ride. And he vetoed less of what Congress did than any other president in history.

The only reason I can imagine why a person who is not “evil” (to use a word he favored), completely uninformed, or thoughtless would favor Bush is because he wasn’t a Democrat. Not that there’s any real difference between the two parties anymore…

As disastrous as he was, I rather hate to put him in competition for “worst president” in the company of Lincoln, McKinley, Wilson, the two Roosevelts, Truman, Johnson, and Nixon. He is simply too small a character – psychologically aberrant, ignorant, unintelligent, shallow, duplicitous, small-minded – to merit inclusion in any list. On second thought, looking over that list of his personal characteristics, he’s probably most like FDR, except he lacked FDR’s polish and rhetorical skills. I suspect he’ll just fade away as a non-entity, recognized as an embarrassment. Not even worth the trouble of hanging by his heels from a lamp post, although Americans aren’t (yet) accustomed to doing that to their leaders. Those who once supported him will, at least if they have any circumspection and intellectual honesty, feel shame at how dim they were to have been duped by a nobody.

The worst shame of Bush – worse than the spending, the new agencies, the torture, or the wars – is that he used so much pro-liberty and pro-free-market rhetoric in the very process of destroying those institutions. That makes his actions ten times worse than if an avowed socialist had done the same thing. People will blame the full suite of disasters Bush caused on the free market simply because Bush constantly said he believed in it.

And he’s left OBAMA! with a fantastic starting point for what I expect to be even greater intrusions into your life and finances. Eventually, the Bush era will look like The Good Old Days. But only in the way that the Romans looked back with nostalgia on Tiberius and Claudius after they got Caligula. And then Nero. And then the first of many imperial coups and civil wars.

Only by looking at the past can we make sure that history won’t repeat itself. But most of the time, Doug and his co-editors of The Casey Report look at the future. They analyze budding trends for potential money-making opportunities and share that research with their subscribers… usually for two- or three-digit gains. One of their favorite investments of 2009 is a play on an economic inevitability that is almost guaranteed to bring early birds big returns. Read more here.

Tuesday, August 18, 2009

It's amazing how a good budget crisis can make a Libertarian out of any politician. "Can we tax it if we legalize it?"

First it was the Hippy Lettuce on the table for legalization in my home state, the People's Republic of California - and now - online poker!

California Senate Pro Tem Darrell Steinberg said today he's open to the idea but wants more time to study it (ie. more time to gauge the potential tax revenue) reports the Sacramento Bee.

Imagine what kind of fun we're missing out on at a national level, all because the Federal Government isn't required to balance a budget? We could be getting a heavy dose of sex, drugs, and rock and roll poured down our throats by Uncle Sam, in an attempt to raise some tax revenue to balance the budget!

"No Uncle Sam, please not another hooker...I gotta go to work!"

Hey if we have concerts to benefit victims of natural disasters and such, why not dust of Kenny Rogers and have him go acoustic for this cause? Come to Sac, Kenny - beer's on me!

Famed Silicon Valley law firm Fenwick & West recently release their latest Venture Capital Survey for the 2nd Quarter of 2009. The survey is a great resource, and I'd imagine an even better marketing/PR piece for Fenwick.

Their survey results pretty much confirmed what I'm observing in the startup trenches here in Northern California - that private valuations are still in the tank, and funding is as tough to come by as it's been for a long while.

While the valuations of private companies fell just as hard, or perhaps even harder, than publicly trades ones, during the recent leg down, the Green Shoots Rally has not trickled down to private companies. At least not yet. Funding is slow, valuations are low, and liquidity events are few, far between, and modest.

With the IPO market drying up for venture capital and angel investors, that leaves an acquisition as the only remaining "exit strategy". And big companies, every entrepreneur's dream acquirer, are no different than your Average Joe investor - they like to acquire companies when times are good and valuations are high.

Paradoxically, during times like these, they are slower to buy, even though valuations are much lower. Though I should add that you'll typically see a lot more "dumb" money being floated for acquisitions when times are good, for "strategic" purposes. Perhaps this is a more grounded reality that we're living in.

Personally I think that the startup world must also adapt to this new reality of the financial universe - and this is something I've been trying my best to get my team to buy into. Though there could be a reason why most successful startups are led by eternal optimists who are not likely involved in Elliott Wave Theory and Inflation/Deflation debates!

When times are good, I'd say sure, go raise some capital at a nice valuation, build your company, and sell it off before you burn through it all! But I think this is now a playbook from a past era. Bootstrapping will become a sexier option...mostly because it's becoming the only option! It's either that, or seriously dilute your stake in the company in exchange for raising capital - there's no free lunch any longer.

And getting to cash flow positive is more important than ever...because you don't know where that next wave of financing will come from. And what terms/rates it will carry - if it's even available.

So, at least from my perspective, the financial fun we banter and debate about here does really carry over into "real life" - pretty cool, huh? :)

Sunday, August 16, 2009

Interesting times in the markets. US equities have now completed a standard fare "Fibonacci retracement" off of the March 6 lows. Now, where to from here?

Bulls and bears alike conceded that a strong rally was quite probable. Now that it's happened, what can we expect?

There seem to be two or three prevailing market outlooks today - and all 3 are quite different!

1. We've averted armageddon. Now it's back to business as usual, albeit at lower levels. How much lower is the big question.

2. We haven't yet seen the bottom of this, and the March 6 lows are destined to be taken out. This is nothing more than a parallel universe to 1930.

3. This rally was engineered by the government and driven by the printing of money. Inflation has shown up sooner than expected - thus we should pile into gold, silver, and metals while we still can.

If you discount the less dramatic "Golilocks scenario" of #1, then you're left again with inflation and deflation staring you in the face.

Both sides of the debate have strong arguments for - and against. It's one of the most intellectually challenging forecasts that I can remember seeing in my (young) investing career.

I've accepted the fact that I'm not as smart as the gurus on both sides of the debate...if they can't figure out which it will be, how can I!

While, as regular readers know, I've recently warmed to the deflationary outlook, I'd still like to hedge my bets in case I'm wrong.

So, though I'm not doing much trading, I am watching the commodity sector closer than every. You'll recall that commodities, one by one, rolled over in early 2008, prior to the equity markets. I've come to believe that commodity prices are "smarter" economic forecasters than, say, the S&P 500.

Here are three charts that I pulled up this evening, which appear potentially ominous, at least in the short term.

Bottom Line: There appears to be A LOT of optimism priced into, well, just about everything right now. If US/global growth disappoints later this year (hard to imagine it won't), we could be in for another leg down. So, take heed to these potential leading indicators!

How Productivity May Hold the Secret to the Inflation/Deflation Outcome

My good friend Jonathan Lederer, President of Lederer Private Wealth Management, an investment advisory firm based quite close to my home here in Sacramento. Every quarter, Jon creates a fantastic update and outlook for his clients, where he dives into the current economic situation, and often applies a unique approach to the markets.

Jon really outdid himself in his Q3 update for 2009 - when he was kind enough to forward me a preview copy of his newsletter, I said: "Jon - this rocks! Can we please post this on the blog?"

No new trades this week...cotton closed "limit down" on Friday after rallying earlier in the week.

Fundamentals for cotton appear to be quite favorable, and these prices should be a bargain. However if we are, in fact, in a Global Depression, we may very well see cotton, and other commodities, roll over.

Recall in early to mid 2008, commodity prices peaked before the broader equity indices - rolling over one by one as a precurser to the Great Deleveraging. Keep an eye on the commodity sector this time around, as it may serve as our canary in the coal mine.

Cotton continues to "range trade".

(Source: Barchart.com)

And, as mentioned last week, I'm planning to "go long" the dollar index very soon.

Wednesday, August 12, 2009

Part I - Prechter believes the dollar has bottomed, because of the formation in the Elliott Wave pattern, and also the extreme bearish sentiment we're seeing.

Part II - He explains his deflationary depression hypothesis and why he believes the next big phase thing we'll see will be a massive "credit implosion" - which will set off a mad dash for dollars.

I really love his line:

This is how markets work - they give you a story at the bottom, and a story at the top.

He shared this when asked about the mainstream reaction to the stock market rally (inflation and commodities are back, etc). Prechter believes that markets make the news, not the other way around.

If you enjoy Prechter's insights, they have a lot of great, free content available if you sign up for Club EWI -now's actually a good time to do it, as they're giving away a free Ebook until the end of the week.

We will, of course, continue to cover his analysis here - I'm a big fan and an EWI subscriber myself. And I have a sneaking suspicion that as crazy as his theories can sound, he might be right on the ball here - it wouldn't be the first time Prechter's contrarian views were correct - so I am listening and following closely.

So which will it be...IN-flation, or DE-flation? That's the $52 trillion question at this point. There are many worthy opinions to consider on each side of the debate. But who's right, and who's wrong?

I think it's important for us individual investors/traders to keep an open mind to all thoughtful, intelligent argumets. Which leads me to the stellar guest piece of inflation/deflation analysis that I'm excited to share with you today.

My good friend Jonathan Lederer is President of Lederer Private Wealth Management, an investment advisory firm based quite close to my home here in Sacramento. Every quarter, Jon creates a fantastic update and outlook for his clients, where he dives into the current economic situation, and often applies a unique approach to the markets.

Jon really outdid himself in his Q3 update for 2009 - when he was kind enough to forward me a preview copy of his newsletter, I said: "Jon - this rocks! Can we please post this on the blog?"

So without further adieu, here a very objective, insightful look into the inflation/deflation situation. While Jon currently sits on the other side of the fence from me here (and we definitely hassle each other about this!) - this is a must-read for all serious investors, no matter which side of the inflation/deflation debate you believe right now.

It will definitely challenge your thinking and provide you with some new ways to look at this debate, especially how lagging productivity may turn out to be a dark horse deciding factor.

The outlook for inflation has far reaching implications on many aspects of financial decision making. In the investment-management arena, inflationary expectations help shape asset-allocation strategies because certain asset classes (e.g., precious metals) perform better in high inflation environments while others (e.g., long-term government bonds) usually outperform when prices are stable or declining. Correctly determining which asset classes to over- and underweight is vital to generating competitive perfor- mance over time.

Following this recent historically severe financial crisis, the chasm between inflationary expectations is very deep. On one hand, many reputable economists have made compelling cases that low inflation or even deflation will persist well into the next decade. At the same time, others, including me, are concerned about higher inflation starting next year.

And if one believes Federal Reserve policy makers and the markets (see Figure 1), inflation will remain within a moderate 1-2% range for many years to come. (And why shouldn’t we believe the Fed after its interest-rate policies earlier this decade helped facilitate one of the worst financial crises during the past 100 years?)

Please click to enlarge.

While I would concur that slack labor markets, excess production capacity, and consumer deleveraging will lead to a low inflationary environment during the next 3-6 months, I still believe that the bigger risk is higher inflation down the road. As the economy begins to stage a recovery (albeit a moderate one), the combination of accommodative monetary policy and delayed government stimulus is likely to add fuel to the inflationary fire.

Perhaps more importantly, I would argue that lower private investment this decade will continue to hamper productivity levels, making it more difficult to achieve healthy economic growth and low inflation concurrently. When one also considers rising government budget deficits and an escalating U.S. national debt, the case that inflation will be higher than what the markets are currently pricing in becomes even stronger.

The Case for Low Inflation

If one observes Figure 1 (above) showing the 5-, 10- and 20-year TIPS spreads, which measure the difference between yields on Treasury Inflation Protected Securities (TIPS) and yields on Treasuries of equivalent maturities, one can see that the markets are currently pricing in modest inflation for some time.

Meanwhile, many economists have made persuasive cases for low inflation or even deflation well into the next decade. Their arguments are predicated primarily on the combination of slack labor markets, excess production capacity, and the overhang from an over-indebted consumer. Moreover, they note a recent breakdown in the relationship between money supply and inflation, citing the past 25 years when prices increased at a much lower rate than the money supply.

Slack Labor Markets

Recent history has shown that there is a relatively strong inverse relationship between unemploy- ment levels and wage growth and that wage growth and inflation rates are highly correlated (see Figure 2).

Please click to enlarge.

Due to the current recession’s severity, unemployment has spiked from 4.9% in January 2008 to 9.5% (June 2009). Considering the greater labor supply from more people being out of work, workers are now less able to command higher wages from employers. And with substantially lower labor union membership and more globalized labor markets relative to the 1970s (when wages actually increased with unemployment levels), it is difficult to envision higher wage pressures during the next 12 months even if the economy begins to recover. The absence of substantial wage growth would eliminate a key inflationary factor.

Excess Capacity

As a result of last year’s credit crunch, worldwide demand fell drastically, causing inventories to rise and manufacturers to scale back production. With industrial production virtually falling of a cliff, capacity utilization has dropped precipitously in most developed economies, including the United States. As Figure 3 shows, factories and other manufacturing facilities are operating well below their potential, thus reducing the likelihood that they will raise their producer prices in the near future.

Debt Overhang

Despite the U.S. consumer in- creasing his savings rate from literally nothing in parts of 2005 and 2006 to nearly 7% in June 2009, total consumer debt to disposable income ratios remain elevated.

Given higher unemployment, coupled with a depressed housing market and a banking sector still reluctant to extend credit, there is a strong likelihood that consumers will continue to deleverage by saving money and reducing their debts. In doing so, they would be consuming less, thereby impairing economic growth and price levels.

One need look no further than Japan during the last two decades to observe the long-term defla tionary effects of a debt overhang. Such an example provides a strong case against higher inflation during the years ahead.

Money Supply and Inflation

In theory, if the money supply increases, higher inflation should result because there is more money pursuing the same amount of goods and services. Empirically, the U.S. inflation rate generally tracked growth in the money supply from 1960 through the early 1990s. However, since that time, the relationship has deteriorated somewhat (as shown in Figure 5).

Those in the low inflation / deflation camp point to this breakdown and argue that the sizable increase in money supply during the past year (9% growth in the M2 money supply from June 2008 to June 2009) will not necessarily drive price levels materially higher.

The Case for Higher Inflation

Despite the deflationary forces mentioned in the previous section, I continue to believe that longer-term inflation will exceed what the market is currently forecasting. Once the economy begins to recover (the capital markets appear to be pricing in a recovery later this year), I think the combination of the Federal Reserve’s extremely accommodative monetary policy and delayed federal government stimulus will add upward pressure on prices.

I also think that subpar productivity growth resulting from declining private investment this decade will make it more difficult to achieve healthy economic growth at lower inflation levels. Moreover, considering the large U.S. government budget deficits and the inability of lawmakers to exercise fiscal restraint in the face of looming entitlement expenditures (e.g., Medicare and Social Security), I remain concerned that the U.S. government may keep resorting to the printing presses well into the next decade.

Loose Monetary Policy

On the heels of one of the worst recessions and credit crises since the Great Depression, I have found it surprising that inflation rates have not fallen more since last fall. As noted previously, core consumer prices, which exclude volatile food and energy prices, have still risen nearly 2% during the past 12 months in the face of higher unemployment, lower capacity utilization, and consumer deleveraging. I would argue that one of the primary reasons price levels have continued to increase has been the Fed’s extremely accommodative monetary policy.

Since last fall, the Fed has thrown massive amounts of money into the financial system via both traditional means (e.g., lowering the Fed-Funds target rate) and unprecedented methods (e.g., providing subsidized financing to facilitate toxic-asset purchases) to try and stave off a deflationary spiral. While these maneuvers appear to have effectively warded off the Great Depression Part II, I am concerned that the Fed will have a difficult time unwinding these moves once an economic recovery starts to materialize.

Though the Fed’s new ability to pay interest on bank reserves will certainly help (because banks will have less incentive to lend out money if the Fed pays attractive rates on reserves), I do not think it is realistic to expect Fed policy makers to time their policies effectively. Considering that the Fed’s lax monetary policies played a significant role in the stock-market bubble during the late 1990s and the housing and credit market bubbles this decade, it should be evident that Fed policy makers have often been mistake-prone with respect to taking proactive steps to slow excessive growth.

In addition, with high unemployment levels and a President and Congressional leaders focused on adding jobs, the Fed will almost certainly be under immense political pressure to not take measures that would slow economic growth and proactively fight inflation.

Please click to enlarge.

Delayed Stimulus

On February 13, Congress passed a $787-billion stimulus package in attempt to spur an economic recovery. According to the Congressional Budget Office, nearly $185 billion of the stimulus is scheduled to be spent in 2009, with another $400 billion in 2010 and an additional $134 billion in 2011. Most of the remaining funds (roughly $70 billion) have been allocated to the years 2012-2014. Incredibly, of the stimulus money already available, only 35% has been paid out. (The government behind schedule due to inefficiencies – who could have predicted?)

Should the economy start to recover later this year, I fear that the massive amounts of stimulus money entering the system will drive inflation higher in 2010. Based on the most-recent U.S. economic figures, the $400 billion of stimulus in 2010 would addnearly 3% to gross domestic product (GDP) levels, excluding any multiplier effects.

Lower Productivity

Going into the next decade, I am concerned that lower productivity growth in the United States due to years of underinvestment will make it more difficult to achieve healthy economic growth without higher inflation.

When analyzing U.S. GDP data this decade, one can observe how the debt-fueled excess consumption since 2000 has resulted in less financial resources being allocated toward private investment, a key to long-term prosperity. Private investment impacts productivity growth, which enables producers to supply more goods and services at a lower cost. For this reason, countries that are more productive have higher standards of living.

I would argue that the United States during the post-war period provides several excellent contrasting examples of how productivity can impact inflation.From 1966-1982, private investment in the United States grew at a relatively tepid pace, falling below consumption growth and barely outpacing growth in government spending. As Figure 7 (below) shows, productivity growth averaged less than 3% (compound average growth rate, or CAGR) during this period.

Please click to enlarge.

Perhaps not coincidentally, core inflation hit elevated levels during the 1970s and early 1980s. While oil-supply shocks and flawed government policies certainly had a detrimental impact on inflation, I believe that the meager productivity growth also played a pivotal role.

From 1983-2000, private investment grew at a very healthy 6% rate, outpacing consumption and government spending growth by a wide margin. Not surprisingly, productivity increased at a 4.1% CAGR, while real GDP grew at a healthy 3.6% average pace. Even with substantially higher economic growth, the average inflation rate fell by nearly half (when compared to the 1966-1982 period), proving, in my opinion, that productivity growth is a vital ingredient to ensuring healthy economic growth without high inflation.

Since 2000, however, when debt-fueled excess consumption has shifted resources away from private investment (as consumers chose to spend instead of investing their capital in wealth-creating projects), private investment levels have literally declined. As a result, the rates of both productivity and GDP growth have fallen this dec- ade. While inflation rates have also been lower, I fear this trend may change relatively soon.

The Impact of Deficits

With the U.S. federal deficit recently reaching $1 trillion, the ratio of federal debt to GDP is expected to rise from 41% (in September 2008) to 55% by this September, according to the Congressional Budget Office. I fear such structural deficits and the rising national debt will amplify inflationary forces into the next decade for several reasons.

First, government budget deficits can crowd out private investment over time because higher interest rates (which result from lenders demanding greater compensation for the increased credit risk due to the escalating national debt) drive up the cost of investment capital.

While higher interest rates can slow the pace of economic growth and put the brakes on inflation, the longer-term impacts on investment and productivity growth can prove detrimental.

And though interest rates have fallen during the past 25 years while the national debt has risen, I believe this trend could change considering that rates are already near historically low levels.Second, as debt levels rise, governments have an incentive to print more money and inflate their way out of debt (see Germany post-World War I and Zimbabwe today for extreme examples).

Considering the U.S. structural budget deficits and the inability of lawmakers to exercise fiscal restraint even in the face of looming entitlement expenditures, I am concerned that the printing presses will be very busy during the coming years, thereby increasing the money supply and inflationary forces. (We will see if the relationship between money supply and inflation will remain weak if productivity growth keeps declining).

Asset Allocation Strategies

Given my view that inflation rates will exceed what the markets are currently pricing in (using the TIPS spread as a proxy), I would recommend overweighting asset classes that should provide an effective hedge against inflation.

These asset classes include commodities (particularly precious metals), real estate, and TIPS. At the same time, in light of the very plausible case for low inflation or even deflation, it is important to maintain a diversified portfolio that includes exposure to long-term Treasury bonds and cash, which somewhat counterintuitively can provide a slight hedge against inflation (assuming the Fed were to raise short-term interest rates to try and maintain price stability).

Conclusion

It is difficult to remember a time in recent history when the gulf between inflationary expectations has been so wide. With all the uncertainty behind today’s inflation debate, I find it fascinating that the markets appear to be pricing in a long-range scenario where the Fed masterfully orchestrates monetary policy (to maintain core inflation within the Fed’s preferred 1-2% range). Considering the Fed’s track record of fueling bubbles during times of much less economic uncertainty, I would argue that it is a leap of faith to think that policy makers will get it right this time. Unfortunately, because of irresponsible fiscal and monetary policies this decade that came at the expense of investment-led productivity, I think we could literally be paying the price for years to come.

Thanks again to Jonathan Lederer for his sharing his excellent inflation/deflation analysis with us. And please be sure to check out his website, which contains more outstanding content! -Brett

Monday, August 10, 2009

We keep hearing how US households are paying off their debts. The important question is - how much debt is left to be paid off?

For some insights into how much painful deleveraging may be left - I'd like to share what Bill Bonner wrote in today's Daily Reckoning (an excellent free email newsletter by the way):

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Harvard professor Ken Rogoff says it will take 6-8 years for households to reduce their debts to a more sustainable level. Let's see. We reported on Friday that the big upswing in credit over the last 60 years added about $35 trillion in excess debt to the system. But not all of that is private debt.

Taking the period of the bubble years, in 2000 total debt in the United States came to $26 trillion. Now, it's twice that amount - $52 trillion, of which $38 trillion is private...or more than two and-a- half times GDP. At this level, the private debt absorbs roughly one out of every seven dollars in consumer earnings - in interest and principal payments.

If the private sector undertook to reduce debt back to 2000 levels, it would mean eliminating all the debt accumulated during the bubble years - or about $19 trillion. How long will it take to pay down, write off, inflate away and otherwise shuck $19 trillion? Well, inflation is running below zero - so that is not now a source of debt reduction.

Between write-offs and pay-downs, about $2 trillion has already been cut - over, very roughly, the last 2 years. At least the math is easy.

At that rate, it will take 19 years.

Now, let's go back and look at the Japanese. How long have they been deleveraging? Gosh all mighty...19 years. From 1990 to 2009.

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